Financial advisers often refer to portfolio diversification in terms of a core/satellite form of portfolio construction. In general terms, the “core” portion of the portfolio would be those parts that an advisor would intend to hold through all markets. These positions tend to be a passively managed index fund of domestic large companies, like an S&P 500 Index. The risky parts of the market, like small cap equity and emerging markets, make up the satellite portion of the portfolio. An adviser will attempt to be more tactical in their approach to investing the satellite positions, generating more turnover as they attempt to improve returns.
A core/satellite approach has merit, unless it becomes a form of market timing in disguise. Changes to the portfolio can be costly. There are transaction costs in the form of fees. Potential missed opportunities when changes are occurring can also be expensive if you are out of the market when there is a big move. Finally, there are taxes to consider when making changes in a taxable account.
We utilize this approach only in the context of rebalancing. The risky parts of the market are the most volatile, and require more maintenance. The emerging markets gained nearly 20% in 2010, according to Lipper, only to drop 20% in 2011. It’s important to rebalance volatile positions in order to capture some of the gains in up markets and avoid giving everything back when they go out of favor.
We prefer to own the satellite positions in a client’s Roth IRA or other tax deferred accounts. This eliminates the tax consideration when the size of the position needs to be adjusted. Core positions are more ideally suited for the taxable account, since changes should be minimal. The return generated from core positions will mostly be in the form of qualified dividends and long-term capital gains. These types of earnings have a lower tax treatment. Investing tax efficiently and limiting turnover will help keep the costs down when utilizing a core/satellite approach.